The most important job the Fed has is to manage the nation’s money and the overall economy. Controlling the inflation rate and maintaining employment and production aren’t easy tasks. The Fed has to have some pretty hefty tools up its sleeve in order to influence the economy of an entire country — especially one the size of the United States. The Federal Reserve System (aka ‘The Fed’) has to be able to affect the rate at which consumer banks and financial institutions create “checkbook” money for customers through the loans they grant and investments they offer. They do this by influencing short-term interest rates and the amount of money in circulation.

But how does it do that? The Fed uses three tools: How do loans “create” money? When banks loan money, that money is spent on goods or services. These goods or services create income for the people providing them, which they in turn spend on other good and services. When lots of loans are made, even more spending is done and more money is pumping through the economy. When the Fed sees that too much money is going through the economy and prices are rising too quickly (inflation), they put the brakes on by selling securities. This reduces the amount of reserves available to banks, causing interest rates to rise, and banks will not make as many loans because it costs more for consumers to borrow. Ultimately, the economy slows down and inflation slows down with it.

The Federal Reserve System has the below tools in there inflation controlling toolbox.

The Reserve Requirement
In order to combat the problems of insufficient cash reserves (and the inability to pay depositors) that were faced before the creation of the Federal Reserve System, banks now have to set aside a certain amount of cash in “reserve.” The reserve balance that banks must maintain is typically a percentage of their total interest-bearing and non-interest-bearing checking account deposits (currently 3% to 10%). In other words, the amount of a bank’s required reserves will fluctuate depending on their account totals. The reserve is very important because it helps to ensure that the bank will always be able to give you your money when you ask for it.

This percentage of required reserves directly affects how much money they can “create” in their local economies through loans and investments. It is this connection between the required reserve amount and the amount of money a bank can lend that allows the Fed to influence the economy. If the reserve requirement is raised, then banks have less money to loan and this will have a restraining effect on the money supply. If the reserve requirement is lowered, then banks have more money to loan.

Reserve money is used to process check and electronic payments through the Federal Reserve and to meet unexpected cash outflows. These reserves can be held as “cash on hand,” as a reserve balance at a regional Reserve Bank, or both.

Although the Fed has the power to do so, changing the amount of reserve cash a bank has to have can have dramatic effects on the economy; for this reason, this tool is rarely used. The Fed more often alters the supply of reserves available by buying and selling securities. When the Fed sells securities, it reduces the banks’ supply of reserves. This makes interest rates go up. When the Fed buys securities, it increases the banks’ supply of reserves. This makes interest rates go down.

All of this buying and selling is referred to as open market operations (discussed below).

In the event that a bank’s money supply drops below the required reserve amount, that bank can borrow either from another bank or from a Reserve Bank. If it borrows from another bank’s excess reserves, then the loan takes place in a private financial market called the federal funds market. The federal funds market interest rate, called the funds rate, adjusts according to the supply of and demand for reserves.

If a bank chooses to borrow emergency reserve funds from a Reserve Bank, then it pays an interest rate called the discount rate.

The Discount Rate
The “discount rate” is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.

The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed’s monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.

Changes in the discount rate can affect:

Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)

Other open market interest rates in the economy (because of its “announcement effect”)

Open Market Operations
The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.

Here’s how it works. The Federal Reserve purchases securities from a bank (or securities dealer) and pays for the securities by adding a credit to the bank’s reserve (or to the dealer’s account) for the amount purchased. The bank has to keep a percentage of these new funds in reserve, but can lend the excess money to another bank in the federal funds market. This increases the amount of money in the banking system and lowers the federal funds rate. This ultimately stimulates the economy by increasing business and consumer spending because banks have more money to lend and interest rates are lowered.

When the Fed wants to decrease the money supply, it sells securities. That transaction deducts the purchase amount from the bank’s reserve (or the dealer’s account). This reduces the amount of money the bank has to lend in the federal funds market and increases the federal funds rate. This move ultimately slows the economy down by decreasing the amount of money banks have to loan, which increases interest rates and typically reduces consumer and business spending.

These decisions are made by the Federal Open Market Committee(FOMC), which consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four rotating members from the other eleven Reserve Banks. This committee has eight meetings per year to discuss and direct the monetary policy. Additional emergency meetings are called when needed. The FOMC specifies either a quantity of reserves to be purchased or sold or a specific change in the federal funds rate. (The federal funds rate is the interest rate at which banks lend reserves to other banks.)

by Lee Ann Obringer

Apply now for a no obligation mortgage loan quote.